Definition
Passive activity income is income generated by two main avenues:
- Trade or business activities in which the taxpayer does not materially participate.
- Rental activities, irrespective of the taxpayer’s level of participation.
As per IRS guidelines under the 1986 Tax Reform Act, these types of activities are generally considered passive, which means any income derived from them follows specific taxation rules.
Key Points
- Rental activities default to being passive unless there is substantial service involvement, as seen in hotel room rentals or car rentals.
- Real estate income is mostly passive, limiting the ability to use losses to reduce other types of income.
Exceptions
There are noteworthy exceptions to the rule on passive losses:
- Qualified Real Estate Professionals: These individuals are not subject to passive activity rules if they meet specific criteria.
- Active Participants in Rental Real Estate: They may offset up to $25,000 of rental losses against nonpassive income.
- Closely Held C Corporations: May offset passive losses and credits against net active income (but not portfolio income), unlike S corporations.
- Mortgage Interest: Interest on loans for principal or second home residences, even when rented out, is not governed by passive activity rules.
Example
Paul bought an apartment complex in 2013 which resulted in a $30,000 tax loss. If Paul qualifies as an active investor, he can use up to $25,000 of that loss to offset his active or portfolio income. Non-qualifying losses remain suspended unless he generates passive income to offset them.
- Material Participation: Direct involvement in a business activity determining whether an activity is considered passive.
- Active Participation: A less stringent criterion than material participation used to classify real estate investors who may benefit from limited loss deductions.
- Portfolio Income: Income from investments like dividends, interest, and capital gains.
- Qualified Real Estate Professional: A specific designation allowing exemption from passive activity loss limitations for eligible real estate activities.
Frequently Asked Questions
1. What types of rental activities are considered passive?
Most rental activities, such as long-term rentals of apartments and leased equipment, are passive. Exceptions include short-term rentals with extensive service involvement.
2. Can passive activity losses be used to offset other income?
Generally, passive losses cannot offset nonpassive income. However, active participation in real estate rentals may shelter up to $25,000 of these losses per year.
3. Are there exemptions for real estate professionals?
Yes, qualified real estate professionals who materially participate in their activities are exempt from passive activity loss limitations.
4. How does an S corporation handle passive activity income?
S corporations are unable to use passive losses and credits to offset other types of income.
5. What determines if a real estate investor meets “active participation” criteria?
Active participation typically involves making decisions about renting property, approving tenants, or arranging for repairs. The standard is less demanding than material participation.
Online Resources
References
- IRS Publication 925, “Passive Activity and At-Risk Rules.”
- Internal Revenue Code (IRC) Sections impacted by the 1986 Tax Reform Act
Suggested Books for Further Studying
- “Tax-Free Wealth: How to Build Massive Wealth by Permanently Lowering Your Taxes” by Tom Wheelwright
- “Real Estate Investment Trusts: Structure, Performance, and Investment Opportunities” by Su Han Chan, John Erickson, Ko Wang
- “Real Estate Investing for Dummies” by Eric Tyson and Robert S. Griswold
- “The Book on Tax Strategies for the Savvy Real Estate Investor” by Amanda Han and Matthew MacFarland
Real Estate Basics: Passive Activity Income Fundamentals Quiz
### What are the two main sources of passive activity income?
- [x] Trade or business activities where the taxpayer does not materially participate, and rental activities.
- [ ] Any type of income-generating activities.
- [ ] Investments outside real estate.
- [ ] Only income from rental activities.
> **Explanation:** Passive activity income is generated from trade or business activities in which the taxpayer does not materially participate, and from rental activities, regardless of material participation.
### When is a rental activity considered non-passive?
- [x] When substantial services are provided, like in hotel room rentals.
- [ ] When the rental is long-term.
- [ ] When equipment leasing is involved.
- [ ] When no services are provided at all.
> **Explanation:** Rental activities are deemed non-passive when substantial services are provided, such as daily cleaning or concierge services, as found in hotel room rentals.
### What is the maximum rental loss offset allowed for active participants in rental real estate per year?
- [ ] $10,000
- [ ] $15,000
- [x] $25,000
- [ ] $35,000
> **Explanation:** Active participants in rental real estate may offset up to $25,000 of rental losses against nonpassive income per tax year.
### Can qualified real estate professionals use passive activity losses against other forms of income?
- [x] Yes, they are exempt from passive activity loss limitations.
- [ ] No, they must adhere to passive activity loss rules like other taxpayers.
- [ ] Only under certain circumstances approved by the IRS.
- [ ] They can only offset passive income with passive losses.
> **Explanation:** Qualified real estate professionals are not subject to passive activity loss limitations and can use those losses against other forms of income.
### How are closely held C corporations allowed to use passive losses and credits?
- [ ] To offset any kind of income.
- [ ] Only to offset dividend income.
- [x] To offset net active income but not portfolio income.
- [ ] They are not allowed to use passive losses.
> **Explanation:** Closely held C corporations may use passive losses and credits to offset net active income but not portfolio income.
### Which tax publication provides detailed guidelines on passive activities and at-risk rules?
- [ ] Publication 530
- [x] Publication 925
- [ ] Publication 527
- [ ] Publication 500
> **Explanation:** IRS Publication 925 offers detailed guidelines on passive activities and at-risk rules.
### What attribute disqualifies an activity from being classified as passive under IRS rules?
- [ ] Being a leasing activity
- [ ] Generating income
- [x] The taxpayer materially participating
- [ ] Involvement of substantial investments
> **Explanation:** An activity in which the taxpayer materially participates is not classified as passive under the IRS rules.
### How does S corporation handle passive losses according to IRS regulations?
- [ ] They can offset any other income.
- [ ] Can only offset dividends.
- [ ] Treated as capital losses.
- [x] Cannot use passive losses against other income.
> **Explanation:** S corporations cannot use passive losses and credits to offset other types of income as per IRS regulations.
### What primarily separates active participation from material participation?
- [x] The level of involvement in decision-making and day-to-day activities.
- [ ] The income produced by the activity.
- [ ] The size of the rental property.
- [ ] The IRS classification rules.
> **Explanation:** Active participation involves decisions about property management but does not require day-to-day involvement, while material participation demands significant and regular involvement in the activity.
### Under the IRS rules, when can mortgage interest be excluded from passive activity restrictions?
- [x] When the interest is on a principal or second home residence.
- [ ] For any long-term rental property.
- [ ] For commercial property only.
- [ ] When used for high-value properties.
> **Explanation:** Mortgage interest on a principal or second home residence is excluded from passive activity restrictions, even if the residence is rented out.
